60-40 tax treatment in jeopardy?

Regulatory proposals flew fast and furious at the start of 2010, with possible repercussions on banks and taxing rules in particular, but analysts say cooler heads could prevail when it comes time to vote on them.

On Jan. 21, President Obama introduced the so-called Volcker Rule, which is designed to limit the size and trading activities of financial institutions. Named after and proposed with former Federal Reserve Chairman Paul Volcker, the rule would ensure no bank or financial institution that contains a bank will own or sponsor a hedge fund or private equity fund or proprietary trading operations unrelated to serving customers. Industry insiders say the rule borders on reinstatement of the Glass-Steagall Act, instituted during the Great Depression and repealed in 1999, which prohibited a bank holding company from owning other financial companies.

“They’re trying to get the risk off these large investment banks and move it into more of a private institution that’s not backed by the Federal government,” explains Andy Nybo, head of derivatives at Tabb Group. “It’s going to be an ongoing debate. It won’t be a short-term regulatory change.”

Joe Anastasio, partner and capital markets group co-leader at Capco, says, “If this were to pass, it’s Glass-Steagall light. It would be undoing the very thing we did to level the playing field for U.S. banks relative to foreign competition. Instead of being politically motivated by approval ratings, [Washington should do] what’s good for our financial systems.”

Gary deWaal, general counsel at Newedge, says, “There’s no indication that prop trading and brokerage/banking activities gave rise to the financial crisis of 2008. It’s a knee-jerk reaction.” He says the rule is unlikely to pass because the United States could not enact it without the cooperation of international regulators, which it isn’t likely to get.

Washington once again is trying to take away 60/40 tax treatment for traders. The Obama Administration’s 2011 budget proposal, released on Feb. 1, called for eliminating it. Under 60/40 tax treatment, 60% of profits and losses are taxed at the lower long-term capital gains rate and 40% of such gains and losses are taxed at the higher, short-term rate. The U.S. Treasury’s 2010 revenue proposal, released in May 2009, also included a proposal to end 60/40 treatment.

Nybo says any change in tax rates will negatively impact the ability of market makers and traders to provide liquidity to the marketplace. “Wall Street’s fair game for any legislation coming out of Washington these days. They’re looking for potential ways of raising revenue by taxing. It’s a popular target for all sorts of revenue-raising opportunities,” he says.

But it is not Wall St. that will be harmed but LaSalle St., as futures traders and equity option market makers would feel a particular sting if 60/40 is repealed. The Options Clearing Corporation along with all of the U.S. options exchanges stated in a letter to Congress last summer that repeal of 60/40 tax treatment for options market-makers will harm the U.S. financial markets by decreasing liquidity and increasing the cost of hedging stock positions. The letter estimates the change will increase the tax rate for these individuals from a maximum of 23% to a maximum of 39.6% in 2011— a tax rate increase of 72% .